Believe it or not, over the past decade a revolutionary

investing strategy has emerged.

Whether you believe in value investing,

dividend investing or trend following — you

are going to love this, because never before

has one strategy brought them all together.

Introducing: Factor-Based Investing.

Backed up with the gold standard of academic

research and top money managers. From the

world's richest man Warren Buffett to commodities

speculator Richard Dennis (who turned his $1,600

to $200 million in a decade)

This guide shows you exactly how a ridiculously

simple, yet powerful investing approach can

reduce your investment risks, and make you

market-beating returns.

So read on!

FACTOR-BASED INVESTING

(The Unified Strategy of

Investing)

Table of

Contents

What is Factor-Based Investing?

Value and Size Factors Not Warren Buffett’s Brand of InvestingValue Investing Proven By Research

The CNAV StrategyDetermining the Conservative Net Asset ValueCalculating The POF ScoreHow to avoid value traps?

Momentum FactorMomentum Proven By Research

The MODO StrategyHow to Handle Momentum Crashes

Profitability FactorProfitability Proven By Research

The GPAD Strategy

Multi-factor portfolioHow Many Stocks to Diversify Into?

Disclaimer:All information in this book is purely for educational purposes. The Information in this

book is not intended to be and does not constitute financial advice. It is general in

nature and not specific to you. You are responsible for your own investment research

and investment decisions. In no event will Dr Wealth be liable for any damages. Under

no circumstances will the Dr Wealth be liable for any loss or damage caused by a

reader’s reliance on the Information in this report. Readers should seek the advice of a

qualified and registered securities professional or do their own research and due

diligence.

You feel tired after a day’s work.

You wonder what caused the exhaustion since you

have had enough sleep the previous night. Noticing

your eye bags, a sales representative approaches you

to share how the multi-vitamin supplements can help

you get through your day with more vigour.

You listen, and your rational self asks a question.

“How do I know if it really works?”

Similarly, how do you know if a particular

investment strategy would really work?

So you search the internet for answers. You come

across a credible organisation which has conducted

scientific research into the effects of supplements

only to conclude that the benefits are marginal. Since

the research is conducted independently and

replicated by other researchers, you would want to

assign more weight to them rather than your friend

or the salesperson. You would be more inclined to

believe what these doctors, scientists and

nutritionists are saying.

What is Factor-Based Investing?

You want to know if the supplement really works, but

who can you look to for answers? If you attempt to

ask your friends, those who take supplements will say

they work while those who have not will convince you

otherwise. The answers will be biased based on

personal circumstances.

Unable to overcome the doubt, you say ‘no’ to the

sales representative despite his repeated attempts to

convince you.

Your close friend might recommend you a stock

because he has heard some rumours about a

takeover. The stock is going to sell at twice its current

price soon, he whispers. You may have attended a

talk by an investment guru who forecasts boldly that

the market is going to crash and you should sell all

your stocks and stay in cash. Or you might have met

up with a financial advisor who tells you not to listen

to both your friend and the guru and that you should

stick to prudent long term investments. He then

proceeds to show you a set of unit trusts you should

be investing in.

Each is a self-proclaimed expert. Each touts his

method to be the best. Who can you trust?

Can their investment strategy pass the ‘vitamin test’?

Like vitamins, finance has also been backed by

established research. For stocks investing, there are

proven Factors or metrics that will produce higher

investment returns. If you have bought stocks that

exhibit the characteristics, you will achieve better

investment results.

These Factors and metrics have undergone rigorous

statistical tests with decades of data as a validation

process. The studies must also be able to stand

against the stringent peer review process, whereby

the findings remain consistent when other

researchers repeat the tests.

Hence, these Factors can be considered proven and

dependable primary drivers of investment returns.

Here is a simple analogy. If you want to build

muscles you will need sufficient protein in your diet.

Chicken meat is high in protein. Muscles are akin to

investment returns, chicken meat is the asset that

you buy (Eg. Stocks) and protein is the Factor you

seek (Eg. Value).

We will discuss each Factor in more details.

1934 was the year ‘Security Analysis’ was first

published.

Benjamin Graham and David Dodd were the authors.

At that time, investing was largely speculative with

very little talk about stock valuation. Security

Analysis changed all that by dealing with the subject

in depth.

It brought about a paradigm shift for investors and

the financial industry and the book laid the

foundations for investment analysis today. Security

Analysis is a timeless classic and Benjamin Graham

is often referred to as the Father of Value Investing.

Young Warren Buffett (left) and Benjamin Graham (right)

The Father of Value Investing

and His Descendants

Value and Size Factors

Interestingly, Graham did not use the term Value

Investing in his literature. This term was coined after

people realised he has started a movement. The

movement has grown even stronger with the years.

The flag bearer for Value Investing is none other than

Graham’s disciple Warren Buffett.

Few would deny that Warren Buffett is the most

successful investor of our time. He has spoken about

his journey several times on print and on TV. He first

got interested in investing after reading Security

Analysis. He came to know that Graham and Dodd

were teaching at Columbia Business School and he

wrote to Dodd asking to be accepted to the school.

He succeeded.

First edition Security Analysis selling at USD 20,000

Graham had a profound influence on Warren

Buffett’s initial years as an investor. Buffett diligently

followed Graham’s teaching to buy stocks which

trading very cheaply against the value of its assets.

The company he runs today, Berkshire Hathaway,

was one of the cheap stocks Buffett came across in

the early days.

Buffett was not the only disciple. In 1984, Buffett

wrote an article The Superinvestors of Graham-and-

Doddsville in honour of the 50th anniversary of the

publication of Security Analysis.

In the article Buffett shared the market beating

results of several value investing practitioners. It was

a testament for Graham’s investment philosophy and

a tribute to his teacher.

The Superinvestors of Graham-and-Doddsville by Warren Buffett

Fund Manager Fund

Period

Fund

Return

Market

Return

WJS Limited

Partners

Walter J.

Schloss

1956–1984 21.3% 8.4%

TBK Limited

Partners

Tom Knapp 1968–1983 20.0% 7.0%

Buffett

Partnership,

Ltd.

Warren

Buffett

1957–1969 29.5% 7.4%

Sequoia Fund,

Inc.

William J.

Ruane

1970–1984 18.2% 10.0%

Charles

Munger, Ltd.

Charles

Munger

1962–1975 19.8% 5.0%

Pacific

Partners, Ltd.

Rick Guerin 1965–1983 32.9% 7.8%

Perlmeter

Investments,

Ltd

Stan

Perlmeter

1965–1983 23.0% 7.0%

Washington

Post Master

Trust

3 Different

Managers

1978–1983 21.8% 7.0%

FMC

Corporation

Pension Fund

8 Different

Managers

1975–1983 17.1% 12.6%

Value investing is still widely practised today by

legends like Seth Klarman of Baupost Group and Joel

Greenblatt of Gotham Capital.

They are more famous than most value investors

because they share their ideas publicly. Otherwise,

value investors are a pretty reserved bunch and most

prefer to make good money quietly.

Margin of Safety, Klarman’s out-of-print book on Amazon

Klarman’s out-of-print book, Margin of Safety, is

selling close to US$1,000 for a used copy. Greenblatt

is known for his quantitative value investing strategy,

Magic Formula Investing, which has achieved market

beating results since it was published in 2006.

Not Warren Buffett’s Brand

of Investing

Mention Value Investing, and most people would

immediately picture the gentile and avuncular

Warren Buffett. He is the most successful investor in

the world, and such an association is only normal.

However, what we have in mind when we say ‘Value

Investing’ is somewhat different from what Buffett

has in mind. Let us explain.

Warren Buffett was schooled under Benjamin

Graham at the Columbia School of Business. After

receiving his Degree, Buffett went on to work at

Graham’s firm before managing money on his own.

He was a keen follower and a very successful

applicant of Benjamin Graham’s philosophy. He

termed it the cigar butt investment approach and he

explained it in Berkshire Hathaway’s 2014

shareholder’s letter.

Warren Buffett

“My cigar-butt strategy worked very well while I

was managing small sums. Indeed, the many dozens

of free puffs I obtained in the 1950s made that

decade by far the best of my life for both

relative and absolute investment

performance… Most of my gains in those early

years, though, came from investments in mediocre

companies that traded at bargain prices. Ben

Graham had taught me that technique, and it

worked. But a major weakness in this approach

gradually became apparent: Cigar-butt

investing was scalable only to a point. With

large sums, it would never work well.”

What prompted Buffett to give up on buying value

small caps was that he became a victim of his own

success. He made too much money from the strategy

such that his capital became too large to invest in

small and undervalued companies. He admittedly

and regretfully said in 1999 to Businessweek:

“If I was running $1 million today, or $10

million for that matter, I’d be fully invested.

Anyone who says that size does not hurt investment

performance is selling. The highest rates of return

I’ve ever achieved were in the 1950s. I killed the

Dow. You ought to see the numbers. But I was

investing peanuts then. It’s a huge structural

advantage not to have a lot of money. I think I

could make you 50% a year on $1 million. No,

I know I could. I guarantee that. The universe I

can’t play in [i.e., small companies] has become

more attractive than the universe I can play in [that

of large companies]. I have to look for elephants. It

may be that the elephants are not as attractive as

the mosquitoes. But that is the universe I must live

in.”

Buffett met Charlie Munger in the early part of his

career and together they built a new investment

approach that was often in opposition to Graham’s

teachings. While Graham advocated paying for a

fraction of the asset value of a company, Buffett and

Munger had no problem paying above the asset value

as long as they are confident that the company’s cash

flow would outgrow the premium in the future. While

Graham advocated a well-diversified portfolio to

minimise risk, Buffett and Munger swung for the

fences with concentrated bets.

“These were strong divergences from Graham’s

original strategy. Buffett eventually proved that it

was a right move with the amount of wealth he had

gathered applying his new found strategy together

with Charlie Munger.

But as retail investors, we do not have many

advantages if we were to copy Buffett’s approach. His

business acumen and access to management are out

of reach for the average joe. Without which, assessing

the investment potential would be very inaccurate

due to the many assumptions involved.

The good news is that retail investors do have an

advantage that Buffett does not have. We can fully

exploit the Value and Size Factors by sticking to

Graham’s philosophy – buying small and

undervalued companies – the exact method Buffett

made his earlier fortunes with.

Charlie Munger (left) & Warren Buffett (right)

Value Investing Proven By

Research

For the longest time, academics have firmly believed

that the stock market is efficient.

They believed that all the information surrounding a

company or a stock would have been reflected in its

price. Hence, no investor has an advantage over

another.

This rendered stock selection a futile activity. Instead

of expending effort to select stocks, investors should

just focus on asset allocation, diversifying into a large

number of stocks, bonds and cash.

This is known as the Modern Portfolio Theory. It has

since permeated the entire financial industry and has

established itself as the cornerstone of portfolio

management.

Eugene F. Fama (left) and Kenneth R. French (right)

The Cross-Section of Expected Stock Returns, by

Eugene F. Fama and Kenneth R. French, was

published in The Journal of Finance Vol. XLVII, No.

2 June 1992. We will dissect the key findings of this

paper in the following paragraphs.

The Cross-Section of Expected Stock Returns by Eugene F. Fama and Kenneth R. French.

aka Price to Net Asset Value (NAV) ratio

First, Fama and French defined cheapness by Book-

to-Market value. This is an inverse of the more

commonly known Price-to-Book value. This is

appropriate since Book Value is the accounting value

or the net worth of a company, while Market Value is

the price that the investors are willing to pay to own

the company. This is also consistent with how

Graham defined value, buying assets for a fraction of

their worth.

Fama and French complied all the U.S. stocks and

ranked them from the lowest to the highest according

to their Book-to-Market value. They were then

divided equally into 10 groups. The first group

consists of the top 10 percent lowest Book-to-Market

stocks, or the most expensive ones. The last group

consists of the top 10 percent highest Book-to-

Market stocks, or the cheapest ones.

This ranking and grouping was revised annually and

the performance of each group measured from Jul

1963 to Dec 1990. During this period, the cheapest

group gained an average of 1.63% per month while

the most expensive group gained an average of

0.64% per month. There was an outperformance of

0.99% per month buying the cheapest group of

stocks!

Next, Fama and French ranked all the stocks listed in

the U.S. by market capitalisation and again sorted

them in ten groups. The first group consists of the

top 10 percent largest stocks by market capitalisation

while the last group consist of 10 percent of the

smallest stocks.

This ranking and grouping was carried out annually

and the performance of each group was again

measured from Jul 1963 to Dec 1990. The largest

group returned 0.89% per month while the smallest

group returned 1.47% per month, an outperformance

of 0.58%!

Figure 1 – Stocks ranked and grouped by Book-to-Market and their

corresponding monthly returns

Lastly, Fama and French applied both the Book-to-

Market and Market Capitalisation groupings to the

stocks.

They discovered that the smallest and cheapest group

of stocks delivered the best performance in the study

period, with a 1.92% return per month.

This is higher than buying the smallest or cheapest

group independently. This suggests that an

investment style that focuses on small cap value has

a statistical edge to achieve higher returns.

Figure 2 – Stocks ranked and grouped by Market Capitalisation and their

corresponding monthly returns

Over the years, this paper has grown to become the

definitive reference for Factor Investing. The model

within came to be known as the Fama-French

Three Factor Model.

As with all good academic research, it throws up a lot

more questions than it answers. In the process, it

serves as an inspiration for the rest of academia to

seek out other Factors that affect investment returns.

Figure 3 – Combining Book-to-Market and Market Capitalisation Applied

Together (ME refers to Market Equity or commonly known as Market

Capitalisation)

The Conservative Net Asset Value (CNAV) strategy is

a means to exploit Value and Size Factors, focusing

on smaller cap stocks trading below their asset value

(less liabilities). The strategy consists of two key

metrics and a 3-step qualitative analysis.

The CNAV Strategy

#1. Determining the

Conservative Net Asset Value

One of Benjamin Graham’s most famous strategies

was the Net Current Asset Value (Net-Net) whereby

an investor can find bargains in stocks which are

trading below two-thirds of net current assets

(defined as Current Assets minus Total Liabilities).

Walter Schloss kept the philosophy close to his heart

and has applied it throughout his investment career.

He makes a good point about investing in assets,

Walter Schloss

“Try to buy assets at a discount rather than to buy

earnings. Earnings can change dramatically in a

short time. Usually assets change slowly. One has to

know much more about a company if one buys

earnings.”

The late Dr Michael Leong, the founder of

shareinvestor.com explains the concept in his book

Your First $1,000,000, Making it in Stocks.

He prefers to invest in ‘free’ businesses where the

company’s cash and properties are worth more than

the total liabilities. An investor will not be paying a

single cent for future earnings.

The way he frames the perspective is brilliant!

In other words, pay a fraction for the good assets that

the company owns, instead of paying a premium for

future earnings.

We gather a very important principle from these brilliant people – Pay a very low price

for a very high value of assets.

Going one step further, we do not just take the book

value of a company. This is because not all assets are

of the same quality. For example, cash is of higher

quality than inventories. The latter can expire after a

period of time.

Hence, we only take into account the full value of

cash and properties, and half the value for

equipment, receivables, investments, inventories and

intangibles. And only income generating intangibles

such as operating rights and customer relationships

are considered. Goodwill and other non-income

generating intangibles are excluded.

In doing so, the CNAV will always be lower than the

NAV of any stock. This additional conservativeness

adds to our margin of safety.

It is easy to find many stocks trading at low multiples

of their book value. Many of them are cheap due to

their poor fundamentals. Hence, we need to further

filter this pool of cheap stocks to enhance our

probability of success.

#2 Calculating The POF Score

Imagine you are in a fashion shop. The latest arrivals

get the most attention and are sold at a premium

(think hot stocks or familiar blue chips). In a corner

there is a pile of clothes which remained unsold from

the previous season and they are now trading at big

discounts (cold and illiquid stocks).

Not all the clothes in this bargain pile are worth our

time. They must be relatively less attractive since no

one buys them in the first place. However, you can

find nice ones (value stocks) sometimes if you are

willing to dive in and search in the pile.

Although conceptually shopping for clothes and

picking stocks are similar, the latter is actually more

complex to understand and execute properly.

We turn to Dr Joseph Piotroski’s F-score to find

fundamentally strong low price-to-book stocks that

are worth investing in.

He used a 9-point system to evaluate the financial

stability of the lowest 20% price-to-book stocks and

found that the returns are boosted by 7.5% per year.

As we have already added conservativeness in our net

asset value, we do not need to adopt the full 9-point

F-score.

A proxy 3-point system known as POF score would

be used instead. POF is detailed in the following

paragraphs.

Profitability

While our focus is on asset-based valuation, we do

not totally disregard earnings as well.

The company should be making profits with its

assets, indicated by a low Price-To-Earnings

Multiple.

Since we do not pay a single cent for earnings, the

earnings need not be outstanding. Companies

making huge losses would definitely not qualify for

this criteria

Operating Efficiency

We have to look at the cashflow to ensure the profits

declared are received in cash.

A positive operating cashflow will ensure that the

company is not bleeding cash while running its

business.

A negative operating cashflow would mean that the

company needs to dip into their cash to fund their

current operations, which will eventually lower the

company’s NAV and CNAV. The company may even

need to borrow money if their cash is insufficient and

this raises further concerns for the investors.

Financial Position

Lastly, we will look at the gearing of the company.

We do not want the company to have to repay a

mountain of debts going forward. Should interest

rate rises, the company may have to dip into their

operating cashflow or even deplete their assets.

Equity holders carry the cost of debt at the end of the

day and hence the lower the debt, the stronger it is.

How to avoid value traps?

We use a time stop of 3 years to get out of a position.

Behavioural economists, De Bondt and Thaler, came

to the realisation that people do not make decisions

rationally. Their decisions were distorted by the vast

amount of cognitive errors they have to contend with.

Werner F.M. De Bondt Richard H Thaler

Does the Stock Market Overreact? Werner F. M. De Bondt and

Richard Thaler. The Journal of Finance

Vol. 40, No. 3, Papers and Proceedings of the Forty-Third Annual Meeting

American Finance Association, Dallas, Texas, December 28-30, 1984 (Jul.,

1985), pp. 793-805

They were keen to discover how much of this is

translated into stock prices. Are stocks priced

correctly at all? Do investors overreact when it comes

to stock prices?

If they do, does it mean that stocks exposed to good

news have become over-priced? Could it be that

stocks that have had a bad run are actually

undervalued in comparison with the general market?

They set out to test their hypothesis.

They did so by mining price data from the New York

Stock Exchange (NYSE) from January 1926 to

December 1982. In the process, they created ‘Winner’

and ‘Loser’ portfolios of 35 stocks each. These are the

top and bottom performing stocks for the entire

market at each rolling time period.

The hypothesis is straightforward. If there is no

overreaction involved, the winners will continue to

outperform while the losers will continue to languish.

However, if human beings being the imperfect

decision makers they display overreaction to stock

prices on the basis of good or bad news, the winners

will eventually perform in a worse off fashion than

the general market. And stocks in the loser portfolio

will eventually catch up.

This is what they found.

To quote directly from the paper

“Over the last half-century, loser portfolios of 35

stocks outperform the market by, on average, 19.6%,

thirty six months after portfolio formation. Winner

portfolios earn about 5% less than the market. This

is consistent with the overreaction hypothesis.”

From the outcome, there is little doubt investors get

caught up with euphoria and over pay for stocks

having a good run. They also become fearful of poor

performing stocks, selling them and causing their

prices to fall beyond what is reasonable.

Two other details about the study caught my

attention.

De Bondt and Thaler choose the time frame of 36

months because it is consistent with Benjamin

Graham’s contention that ‘the interval required

for a substantial undervaluation to correct

itself averages 1.5 to 2.5 years’.

As the graph has shown, most of the reversal took

place from the second year onwards. This is

consistent with Graham’s observations. It takes time

for the market to eventually function as the

proverbial weighing machine.

Secondly, the overreaction effect is larger for the

loser portfolio than the winner portfolio. Stocks that

have been beaten down due to investors overreacting

to their bad performance eventually recovered faster

and more than stocks whom investors have

overvalued.

In a second study in 1987, Debondt and Thaler found

that investors focused too much on short term

earnings and naively extrapolated the good news into

the future, and hence caused the stock prices to be

overvalued.

They repeated the experiment in the first study,

examining the 35 extreme winning stocks (Winner

Portfolio) and the 35 worst performing stocks (Loser

Portfolio). They wanted to track the change in

earnings per share over the next four years.

They found out that the Loser Portfolio saw their

earnings per share increase by 234.5 percent in the

following four years while the Winner Portfolio

experienced decreased earnings per share by 12.3

percent.

Eyquem Investment Management LLC plotted the

changes in the average earnings per share of these

two portfolios in the following diagram. This was

taken from Tobias Carlisle’s book, Deep Value

The Undervalued Portfolio which had their Earnings

Per Share dropped 30%, went on to improve their

earnings by 24.4 percent in the following four years.

The Overvalued Portfolio, which had 43 percent gain

in Earnings Per Share in the past three years, only

managed to achieve 8.2% in the next four years.

This implies that earnings also tend to revert to the

mean.

The CNAV StrategyChallenges of Implementing

Value and Size Factors

If more people adopt your strategy, would it not stop

working?

If the strategy is so good, why are you sharing it with

everyone?

The truth is, investing in CNAV stocks is very

unnatural and uncomfortable. Not many people are

psychologically capable of investing in this manner.

For example, everybody knows that the strategy to

keep lean and fit is to exercise more and eat less. But

not many people can execute this strategy to achieve

what they want.

Unfamiliar stocks

CNAV stocks tend to be unknown companies which

many investors have never heard of. It is easier to

buy a stock that is a household name than an

unknown one.

Unfamiliar names do not give the sense of assurance

to the investors. Investors subconsciously think that

these companies are more likely to collapse than

ones that they are more familiar with.

The CNAV StrategyProblems Present

These undervalued stocks tend to have problems that

put investors off. The business may be making losses,

the industry may be in a downturn, or simply the

earnings are just not sexy enough.

There are many reasons not to like the stock.

Similarly, it is much easier to invest in stocks that are

basked in good news – growing earnings, record

profits, all-time high stock price, etc.

Investors are willing to pay for good news in

anticipation of better news.

After all, isn’t investing all about buying good

companies and avoiding bad ones?

This problem is a second-level one. The good news

and even potential good news have been factored into

the price.

In fact, investors often overcompensate for the good

news without even realising it.

The CNAV StrategyLow Liquidity

To make things worse, there is little liquidity in

CNAV stocks. The lack of volume increases the

doubts about these small companies. We are wired

with the herd instinct and intuitively believe such

stocks are lousy because few investors are invested in

it. We have always based our judgement on the effect

of the crowd. We want to buy books and watch

movies with lots of good reviews. We like to try the

food with the longest queue. We also apply the same

crowd effect on the stock market to determine if a

stock is ‘good’.

High Volatility

Due to the low liquidity, the bid and ask spread tends

to be wider. This means that a little buying or selling

can move the stock price by large percentages.

Such large fluctuations do not bode well with

investors as most are unable to handle volatility.

Investors tend to overestimate their tolerance for

volatility. They want 0% downside and 20% upside.

Such investments do not exist in this world. It is a

naive demand projected on stock market reality.

Sadly, the only outcome is disappointment for the

investor.

The reason why value investing works in the first

place is because the majority of the investors are

unable to overcome their psychological barriers.

This results in underpricing of value stocks. It is

precisely this mis-pricing that we are trying to

exploit.

Trend followers are a group of traders who believe

that price movements is the most important signal.

Go long if the price trend is up and short if the trend

is down. Such a simplistic notion is often dismissed

by investors who do not share the same belief. Value

investors would find this approach absurd since their

mantra is to buy an asset that has gone down in price

and not buy something when the price has gone up.

Trend following has a history as long as value

investing, with generations of practitioners

delivering above market returns.

Jesse Livermore, one of the first trend followers. He was worth $100 million

(today's money est. $1.1 to $14 Billion) at the peak of his fortune in 1929.

The Father of Trend Following

and His Descendants

Momentum Factor

Richard Donchian may not be a familiar name to

most people. This is despite him being known as the

Father of Trend Following. It was Donchian who

developed a rule-based and systematic approach to

determine the entry and exit decisions for his trades.

The story was written in the book The Complete TurtleTrader by Michael W. Covel

The most famous trend following story has to be

about the ‘Turtles’.

Richard Dennis was a successful trader and

reportedly turned $1,600 to $200 million in 10 years.

He believed that successful trading could be taught

while his friend, William Eckhardt, believed

otherwise.

They had a wager and Dennis recruited over 20

people without trading experience from various

backgrounds. Dennis called his disciples ‘Turtles’ and

taught them a simple trend following system, buying

when prices increased above their recent range, and

selling when they fell below their recent range.

Richard Dennis William Eckhardt

Winning Commodity Traders May Be Made, Not Born. Richard Dennis shared his top 14

commodity-trading advisors trading performance on WSJ.

The more successful Turtles were given $250,000 to

$2 million to trade and when this experiment ended

five years later, the Turtles earned an aggregate

profit of $175 million.

Besides proving that trading success could be taught,

it also showed that trend following strategy can

produce serious investment gains when executed

well.

For time-series Momentum, we decide to go long or

short by looking at the historical prices of a security,

independent of the other securities.

The other form of trend following is known as cross-

sectional Momentum whereby we need to compare

the historical returns among a group of assets to

determine which ones to go long or short.

Both approaches have been proven to produce above

market returns.

Narasimhan Jegadeesh, Ph.D.

Finance, Columbia University

Momentum Proven By

Research

Sheridan Titman, Ph.D.

Carnegie, Finance,

Mellon University

Returns to Buying Winners and Selling Losers: Implications for Stock Market

Efficiency by Narasimhan Jegadeesh and Sheridan Titman [The Journal of

Finance, Vol. 48, No. 1(Mar.,1993), pp. 65-91.]

One of the most widely quoted and influential

research about momentum is Returns to Buying

Winners and Selling Losers: Implications for Stock

Market Efficiency by Narasimhan Jegadeesh and

Sheridan Titman [The Journal of Finance, Vol. 48,

No. 1(Mar.,1993), pp. 65-91.]

Jegadeesh and Titman divided the stocks into 10

groups by their historical performance for the past 3

to 12 months. They went on to observe the

performance of these groups in the next 3 to 12

months. The stock selection was purely based on

historical prices and not by any other valuation

metrics.

The Study proved the Momentum effect – the

Group with the highest historical returns was also the

Group that delivered the highest returns in the

ensuing months!

Figure 4 shows the Group formed by stocks with the

highest past 12 months returns gained 1.74 percent in

the following month while the Group formed by

stocks with the lowest 12 months returns gained 0.79

percent in the following month.

Figure 4 – Average Monthly Returns of Stocks Grouped by Their Past 12 Months

Performance

They also found that the look-back period of the past

12 months returns produced higher returns than

other look-back periods of past 9, 6, or 3 months.

A look-back period of 12 months produced 1.92

percent per month while a look-back period of 3

months produced 1.4 percent per month. There was

an outperformance of 0.52 percent per month. See

Figure 5.

Figure 5 – Average Monthly Returns of Momentum Stocks with Various Look-

Back Periods

Lastly, they found that holding the Momentum

stocks for 3 months would produce higher returns

than holding them for much longer periods.

A holding period of 3 months would gain 1.31 percent

in a month compared to 0.68 percent when holding

the same stocks for 12 months, see Figure 6. This

suggests that returns decline as we hold

outperformed stocks longer than necessary.

Figure 6 – Average Monthly Returns of Momentum Stocks with Various Holding

Periods

The findings tell us that we should use a look-back

period of 12 months and hold the best performing

group of stocks for another 3 months. This resolved

the contradiction with the Value Factor.

In the short run, the Momentum Factor prevails.

Investors will do well to ‘chase’ returns and hold

these winners for a short period of time.

However, in the long run, the mean reversion

phenomenon kicks in. It would be better to buy

undervalued stocks and avoid outperformed stocks if

one plans to hold the positions for years.

Leveraging on the findings from Jegadeesh and

Tittman’s research, we will use a look-back period of

12 months to rank the returns of the stocks. We will

prefer to long the stocks that are ranked in the top

decile for the past 12 months.

Since Momentum Factor relies on prices alone

without the need to analyse the fundamentals of the

underlying businesses, technical analysis would be

more suitable to generate entry and exit signals.

We use the Donchian Channel as the indicator that

was developed by Richard Donchian. The indicator

forms price resistances and supports the highest and

lowest price points in the past 20 days.

We prefer this over the favourite moving average

indicator because the latter provide very little entry

points after a trend is established, while the

Donchian Channel enables an investor to join a trend

easily as soon as prices break above the highest point

in the past 20 days.

Momentum and Donchian Channel are

abbreviated as MODO for this strategy.

Although the MODO strategy can be applied to

stocks, we prefer to use it on ETFs.

The MODO Strategy

This is because individual stocks are often the subject

of corporate actions. In such cases, we need to

calculate and amend orders to accommodate changes

in stock prices due to events like splits, consolidation

and bonus issues.

That would be too much work for short term holdings

(about 3 months).

Hence, we found it much easier and even more

diversified when we use ETFs.

There are over 2,000 ETFs listed in the U.S. and we

could easily find a country, or sector, or an asset class

to long (or short with an inverse ETF).

This has an additional benefit of exposing our Multi-

Factor portfolio to include asset class diversification.

Frog-in-pan Stocks Perform Better

Human beings are slow to react to small incremental

changes but are very alert to sudden large

dislocations.

It is analogous to leaving a frog on a pan and slowly

heating the pan up. The frog would not notice the

gradual increase in heat and hence would not jump

out of the pan. It would have been cooked before it

realised that the heat. On the other hand, the frog

would jump out of a boiling pot of water if you throw

it in.

Stocks that rise up slowly get less attention from

investors as compared to the stocks that have a

sudden jump in prices.

A study titled Frog in the Pan: Continuous

Information and Momentum by Zhi Da, Gurun and

Warachka, proved that stocks with frog-in-pan

characteristics have more superior and persistent

returns than those with more volatile and discrete

price movements.

Using the following diagram to illustrate, Stock A has

a smoother path compared to Stock B even though

their share prices started and ended at the same

values. Stock A is the better choice for a Momentum

play. In other words, the journey matters.

The CNAV StrategyHow to Handle Momentum

Crashes

Momentum has another peculiarity – it backfires

sometimes. Booms and busts are common in the

financial markets and Momentum is particularly

vulnerable when the market recovers.

For example, during the post-Financial Crisis in

2009, you would have lost 163% shorting the weakest

stocks and gained only 8% on the long side.

Overall you would have blown up your account. This

is known as a Momentum Crash.

The CNAV StrategyThere are 3 principles we abide with in order to

mitigate the impact of Momentum Crashes.

First, a Momentum Crash affects the short side

rather than the long side when the market recovers

from a major crash. We only go long on Momentum

counters and avoid shorting or the use of any inverse

ETFs.

Second, we do not take leverage to invest in

Momentum stocks. This is to prevent multiplying our

losses when things do not go our way. It is very

unlikely to blow up our capital when we go long on a

group of stocks or ETFs without leverage.

Third, we pre-determine a sell price before the trend

turns against us. It is commonly known as a stop loss

order whereby our position will be closed if price falls

below this stop order. This is a safety mechanism to

take us out when we are proven wrong by the market.

Lastly, if all the precautions above failed to protect

us, the last layer of defence lies in our Multi-Factor

Portfolio. Within this portfolio, our maximum

exposure to the Momentum Factor is capped at 20%.

We will be well protected by the Value, Size and

Profitability Factors.

The CNAV Strategy

Challenges of Implementing

the Momentum Factor

Flight when we should FIGHT

The MODO strategy uses a price breakout approach

where an investor buys only when the price surpasses

the past 20-day high, and sells when the price

breaches the 20-day low.

Such a breakout approach tends to be low probability

in nature. It would be common for the investor to

take consecutive losses but he must continue to put

in the trades as the opportunities arise.

It is not human nature to keep doing the same thing

that invokes pain in us.

Fight when we should FLIGHT

The investor must be disciplined to take losses to

preserve the capital even when it is painful to do so.

One of the major dangers is to procrastinate taking

losses and harbour the hope that the prices would

recover.

The losses can snowball to larger amounts which

makes them even harder to bear. Eventually these

large losses become a drag on the overall portfolio

returns.

It is common sense for investors to look for

profitable companies and avoid the unprofitable

ones. One way to determine profitability is to focus

on earnings or net profits. Ultimately, earnings

should drive stock prices.

There are few arguments against this point among

investors. Hence, we should be able to make

investment gains as long as we can value a company

by its earnings and pay a price lower than this value.

The obsession with earnings is obvious. Analysts

often make estimates on companies’ next quarter

earnings and stock prices often react according to

how far their reported earnings deviate from

analysts’ estimates.

Although investors agree on the role of earnings, few

agree how best to use earnings to determine the

value of stocks.

Profitability Factor

Profitability Is Key to

Investment Returns

John Burr Williams developed the intrinsic value

concept. He said that the value of a company is based

on the sum of its future earnings and dividends.

Some would go further and use cash flow instead of

earnings since the latter includes the less desirable

non-cash gains.

Regardless, Williams had laid the foundation for

methods like Gordon Growth Model and Discounted

Cash Flow which are widely used today in the

financial industry. Even Warren Buffett articulated

something similar in 1986 with his definition of

owner earnings,

“These represent (a) reported earnings plus (b)

depreciation, depletion, amortization, and certain

other non-cash charges…less (c) the average annual

amount of capitalized expenditures for plant and

equipment, etc. that the business requires to fully

maintain its long-term competitive position and its

unit volume….Our owner-earnings equation does

not yield the deceptively precise figures provided by

GAAP, since (c) must be a guess – and one

sometimes very difficult to make. Despite this

problem, we consider the owner earnings figure, not

the GAAP figure, to be the relevant item for

valuation purposes…All of this points up the

absurdity of the ‘cash flow’ numbers that are often

set forth in Wall Street reports. These numbers

routinely include (a) plus (b) – but do not subtract

(c).”

The bottomline is, valuation of a company’s

profitability is subjective. To complicate the matter,

investors also look at qualitative aspects of a

company to determine its future profitability. This

goes beyond what the financial statements entail.

Philip Fisher’s Common Stocks, Uncommon Profits

was one of the few investing books recommended by

Warren Buffett.

This is a great endorsement from the world’s best

investor. The book is still in print since it was first

published in 1958, further proving the utility and

dominance of his ideas even today.

The thesis focused on finding exceptional listed

companies that offer growth in sales and profits.

Fisher believed that a company would become more

valuable as they rake in more profits.

Hence an investor needs to identify traits that would

allow a company to earn more profits in the future.

He laid out 15 points in his book to guide investors

on evaluating potential companies to invest in.

The evaluation includes the quality of management

and the competitive advantages of the company. You

could see many similarities in Warren Buffett’s

investment philosophy.

Warren Buffett shared the concept of economic moat,

an analogical reference to ancient castles with moats

to ward off attacks. He painted a picture of what

competitive advantage would look like.

Common Stocks, Uncommon Profits by Philip Fisher

Warren Buffett

“In business, I look for economic castles protected by

unbreachable ‘moats’.”

Competitive advantage can be tricky to determine

especially for investors with little experience and

business acumen. Methods like Porter’s Five Forces

are subjective at best and individuals may arrive with

different assessments of competitive advantages.

Luckily, research has pointed out a metric that would

quantify profitability and competitive advantages to a

large extent. This is helpful for investors to

implement an investment strategy with more

objectivity and less personal judgement.

The CNAV StrategyProfitability Proven By

Research

Robert Novy-Marx defined a new paradigm to look at

profitability. Instead of using earnings, he found that

Gross Profitability was a better determinant of future

investment returns.

He documented his research in The Other Side of

Value: The Gross Profitability Premium [Journal of

Financial Economics 108 (2013) 1-28].

His empirical studies proved that stocks with high

Gross Profitability can have equally impressive

returns as with value stocks.

Image taken from University of Rochester

Gross Profitability = Gross Profits divided by

Total Assets.

Gross profits = Revenue - cost of goods sold / cost

of sales

It ignores other costs that do not contribute directly

in the production of a good or provision of a service.

Some would argue the value of gross profits since it

excluded numerous cost considerations such as

marketing costs and depreciation. Others feel that

earnings should be a better metric.

Novy-Marx explained,

Novy-Marx

“Gross profits is the cleanest accounting measure of true economic profitability. The farther down the

income statement one goes, the more polluted profitability measures become.”

Novy-Marx believed that earnings is a ‘dirty’ number

which should not be used in valuation. He went on to

substantiate his point,

“[A] firm that has both lower production costs and

higher sales than its competitors is unambiguously

more profitable. Even so, it can easily have lower

earnings than its competitors. If the firm is quickly

increasing its sales through aggressive advertising

or commissions to its sales force, these actions can,

even if optimal, reduce its bottom line income below

that of its less profitable competitors. Similarly, if

the firm spends on research and development to

further increase its production advantage or invests

in organizational capital that helps it maintain its

competitive advantage, these actions result in lower

current earnings. Moreover, capital expenditures

that directly increase the scale of the firm’s

operations further reduce its free cash flow relative

to its competitors. These facts suggest constructing

the empirical proxy for productivity using gross

profits.”

The reason for using total assets as a denominator in

place of equity was mainly to avoid the differences in

capital structure among the companies.

Some companies take on more debt while others less.

The companies that took on more leverage will have

an advantage as the book value is small

(denominator).

Hence, using total assets would remove the degree of

leverage used by the companies and make the

comparison fairer.

Tobias Carlisle and Wesley Gray, the authors of

Quantitative Value, conducted a separate test on the

range of profitability metrics as shown in the table

below.

With most things equal, a company that generates

more gross profits while using less assets would be of

higher productivity and quality than her competitors.

Novy-Marx ranked the stocks by Gross Profitability

and divided them into five groups. The Group with

the highest Gross Profitability produced a monthly

return of 0.6%, versus a negative return of 0.16% in

the Group with the lowest Gross Profitability, see

Figure 7.

Figure 7 – Average Monthly Returns of Stock Groups By Gross Profitability

Quantitative Value: A Practitioner's Guide to Automating Intelligent Investment and

Eliminating Behavioral Errors by Tobias Carlisle and Wesley Gray.

Earnings / Total Assets

Free Cash Flow / Total

Assets

Return On

Capital

Gross Profits /

Total Assets

S&P 500 Index

Annual Gains

9.84% 10.80% 10.37% 12.56% 10.46%

Tobias Carlisle Wesley Gray

His findings was consistent with Novy-Marx – Gross

Profitability had the best returns compared to either

earnings or free cash flow metrics.

A Profitable Dividend Yield Strategy for Retirement Portfolios [Journal Of

Investment Management, Vol. 14, No. 3, (2016), pp. 1–11] by Fong Wai Mun and

Ong Zhe han.

Fong Wai Mun Ong Zhe Han

Fong Wai Mun and Ong Zhehan further enhanced

the Gross Profitability with Dividend Yield as an

additional criteria. The findings were published in A

Profitable Dividend Yield Strategy for Retirement

Portfolios [Journal Of Investment Management, Vol.

14, No. 3, (2016), pp. 1–11].

Similar to Novy-Marx’s approach, they grouped the

stocks into quintiles by Gross Profitability. They

labelled the highest Gross Profitability group of

stocks as G5 and the lowest Gross Profitability group

as G1.

Separately, they rank the stocks by their dividend

yield and group them into quintiles. The group of

stocks with the highest dividend yield was labelled

D5 while the lowest dividend yield group was known

as D1.

Fong and Ong found that the excess return per

month was 1.04% for stocks that are in both G5 and

D5 Groups, which are higher than the 0.66% in the

G5 group. This enhanced the returns of a portfolio of

Gross Profitability stocks. In fact, the simulated

portfolio was more stable and fluctuated lesser

(lower standard deviation) with the additional

dividend criteria.

The Gross Profitability Assets Dividend (GPAD)

Strategy is developed to identify stocks that possess

the Profitability Factor.

We leverage on Novy-Marx’s Gross Profitability

(GPA) and Fong and Ong’s augmentation of dividend

yield (D) criteria to the GPA to form the core metrics

for our approach.

Hence, it would be convenient to abbreviate the

strategy or stocks with such characteristics as GPAD.

The GPAD strategy relies on relative valuation, which

is unlike the absolute valuation used in the CNAV

strategy.

This means that knowing the value of Gross

Profitability and the Dividend Yield would not

provide sufficient information to make a buy or sell

decision. We would need to know how well this stock

ranked against the rest of the stocks to ascertain

whether they belong to the top 20% group in GPA

(G5) and Dividend Yield (D5). Hence, all the stocks

in a stock exchange have to be calculated and ranked

for this strategy.

The GPAD Strategy

A stock in the G5D5 group is an asset light business,

that has competitive advantage over the other

companies and the management is able and willing

to distribute decent dividends.

Hence, the GPAD strategy is suitable for investors

who seek dividend paying stocks while enjoying

potential capital gains too.

However, the GPAD strategy would penalise Real

Estate Investment Trusts (REITs) despite their high

dividends. This is because properties are capital

intensive and would constitute a large amount in the

denominator of GPA, rendering a low ratio in

comparison to those asset light businesses.

Financial institutions are unique by their own

measure and would also not rank well in the GPAD

criteria.

Marbella – Marriott

Marriott discovered that it would take a long time to

build up capital to buy the next property and convert

it into a hotel.

They figured out that they are known for their

hospitality, and expansion would be easier if they

operate the hotel while others own the properties.

The profits could be shared between the hotel

operator and the building owner.

This model worked so well that allowed Marriott to

be one of the biggest hotel chains in the world, and

many other competitors have used the same model

too.

Secondly, asset light businesses do not require large

reinvestment. Most of the profits could be ploughed

into expansion or distributed as dividends, further

enhancing the competitive advantage and

attractiveness of these businesses.

A stock that is able to produce higher dividends is

likely to see higher stock prices, rewarding the

shareholders with dividends and capital gains.

Gross Profits is the difference between Revenue and

Cost of Goods Sold (COGS).

An asset light business is easier to

scale.

While it is obvious that Revenue growth is a good

sign, it is equally important to watch the COGS such

that it does not grow at a higher rate and cause the

Gross Profit Margin to reduce. COGS are costs

related directly to the production of the goods for

sale. This would be the variable cost of the company

– COGS increases as more goods are sold.

A good company should increase Revenue and lower

COGS at the same time, a sign that it has achieved

economies of scale. A company with larger Gross

Profits should be more advantageous than the

competitors, suggesting competitive advantage is

factored into the GPA metric.

Therefore, a high GPA stock is operationally efficient,

using very little assets to produce high gross profits

than their competitors.

We have also enhanced the stock picking process by

adding Payout Ratio, average Free Cash Flow Yield

and Earnings Yield criteria. Lastly, we also conduct

simple qualitative analysis to identify any possible

risks that might have been missed with the

quantitative approach.

Payout Ratio

The Payout Ratio indicates the fraction or percentage

of the earnings being paid out as dividends.

A low Payout Ratio indicates that most of the

earnings are retained by the company, especially if

the funds are needed to fund growth opportunities.

A high Payout Ratio indicates that most of the

earnings are distributed as dividends, keeping little

funds in the company. Usually mature and profitable

companies are able to maintain a high Payout Ratio.

It shows stability as well as low growth prospect.

We should expect a stock with low Payout Ratio to

produce more capital gain in the future. Assume

Company A and B each earns $1 per share. Company

A decided to distribute $0.20 as dividends and its

Payout Ratio would be 0.2 while Company B decided

to distribute $0.70 as dividends and its Payout Ratio

would be 0.7. Correspondingly, Company A and B

would retain $0.80 and $0.30 per share respectively.

The retained earnings would increase the Net Asset

Value (NAV) / Book Value / Shareholder’s Equity.

In other words, Company A and B’s NAV per share

would increase by $0.80 and $0.30 respectively.

Their share prices should gain by the same amount if

they were to reflect fundamental value of the

companies, hence producing capital gains to the

shareholders.

The Payout Ratio gives us a gauge of the proportion

of returns in the form of dividends and capital gains.

This assumption may not hold when the company

pursue expansion plans. For example, if Company A

invests the retained earnings of $0.80 per share but

wasn’t successful, the $0.80 value might be

destroyed. If successful, the retained earnings might

multiply beyond $0.80 per share, generating more

wealth for shareholders.

A sustainable Payout Ratio would be below 1, so that

the dividends is paid within the amount of earnings.

It is very likely the dividend distribution would drop

the following year if the Payout Ratio is more than 1,

thereby trapping unaware investors who were

misguided by the high dividend yield.

Average Free Cash Flow

Most of the companies use the accrual accounting

format, which simply means that earnings can be

cash and non-cash based.

We will use a lemonade stall to illustrate the

differences:

We can see that the revenue and cash received by the

company may not always be the same amount. This

is the effect of accrual accounting whereby revenue is

recognised after the goods or services have been

rendered. It is independent of whether the cash has

been received by the company.

Given a choice, Scenario C is the best for the

lemonade stall as it is better to collect the cash first

to buy the ingredients for the lemonade, and deliver

later. It is quite difficult for the stall to go bust if they

can continue to receive the cash orders. Scenario B is

the worst since the stall owner always has to fork out

the ingredient costs and run the risk of some

customers defaulting their payments.

Scenario A Scenario B Scenario C

Sold 30 glasses of

lemonade and received

$30 cash payments at

the point of sale.

Delivered 30 glasses

of lemonade to a party

and invoiced the

customer $30.

A customer paid $30 in

cash for 30 glasses of

lemonade to be

delivered to a party next

week.

Revenue = $30 Revenue = $30 Revenue = $0

Cash Received = $30 Cash Received = $0 Cash Received = $30

With this understanding, this is why we cannot rely

on earnings alone and analysing the cash flow is

crucial to any business. A company with losses but

good cash flow will last a long time. A company with

large profits but poor cash flow will run the risk of

bankruptcy.

One of the most stringent ways to analyse cash flow

is to use Free Cash Flow (FCF). It is calculated by

deducting the capital expenditures from its

Operating Cash Flow.

Capital Expenditures (CAPEX) are investments on

fixed costs or long term assets that are crucial to the

operations of the company. In the case of the

lemonade stall, the CAPEX could be flasks, ladles and

dispensers. These are cheap items and we can

conclude that the CAPEX for the business is low and

it should be able to generate good FCF.

Good GPAD stocks should have high FCF since they

are asset-light businesses that require little CAPEX.

They are also more likely to distribute most of these

cash as dividends.

FCF tends to be lumpy as CAPEX may not happen

every year. It is thus more usable to average the FCF

across five years before comparing to the latest

dividend distribution. We deem the dividend

distribution sustainable when the average FCF is

larger than the dividend distributed.

Expected Total Returns From A

Stock (Earnings Yield)

It is important to look at the total returns in a stock

even if you are a dividend investor. Total returns are

essentially dividend gains plus capital gains.

This relates to the payout ratio criteria. If the payout

ratio is low (dividends are low), we expect a higher

capital gain, and vice versa. Hence, we can use

dividend yield and payout ratio to determine the

expected total return of a stock.

For example, if a stock has a dividend yield of 5% and

the payout ratio is 0.8, the expected total gain would

be 5% divided by 0.8 which gives us 6.25% per year.

This isn’t attractive returns and we might just want

to sit this out. In general, we would only invest in the

stock when its total returns exceeds 10% per year.

There are caveats of course.

If a company has some growth prospect, we can

accept below 10% total returns. This is because the

earnings and dividends should grow over time and

we would achieve higher returns in the future. It can

also happen to cyclical stocks such as those in the

commodities industry.

For example an oil and gas stock has a dividend yield

of 5.7% and a payout ratio of 0.7. This stock would

give an expected total returns of 8.14% which is less

than 10%. One can still invest because the current

low earnings was due to the poor outlook for the oil

and gas industry. We should expect it to ‘grow’ back

to previous earnings when oil prices recovers, and we

should be able to get more than 10% total returns per

year in the future.

The way we have estimated the total return is similar

to the earnings yield of a stock, which is the inverse

of its PE ratio (a value metric). A PE 10 stock would

give you an earnings yield of 10% (1/10). A PE 5 stock

would be an earnings yield of 20%. Hence, when we

set an earnings yield of 10%, we are indirectly buying

stocks with PE less than 10.

This concept of estimating annual returns cannot be

used for stocks in general because of accrual anomaly

– stocks with high earnings but largely non-cash

basis would have lower returns. This means that even

a low PE stock or high earnings yield stock may

underperform if the earnings are non-cash in nature.

It works for GPAD stocks because they have been

assessed to have largely cash-based earnings and

moreover able to distribute cash dividends. This

helps us minimize the accrual anomaly effect and the

earnings yield becomes more accurate as a measure.

Benjamin Graham has always preached a well-

diversified portfolio of stocks, on top of the margin of

safety that can be achieved from each stock.

This is because an investor neither know which stock

would rise in price in order to weigh a lot of capital

prior to the price movement, nor does the investor

know which stock would deteriorate in the

fundamentals to warrant a sell off.

In fact, you would just need a few stocks with big

runs to contribute to the overall returns in your

portfolio. Walter Schloss had large number of stocks

and still achieved 15.3% returns per year and Warren

Buffett praised Schloss for that,

Multi-factor portfolio

How Many Stocks to

Diversify Into?

“Walter has diversified enormously, owning well

over 100 stocks currently. He knows how to

identify securities that sell at considerably less than

their value to a private owner. And that’s all he does.

He doesn’t worry about whether it it’s January, he

doesn’t worry about whether it’s Monday, he doesn’t

worry about whether it’s an election year. He

simply says, if a business is worth a dollar

and I can buy it for 40 cents, something good

may happen to me. And he does it over and over

and over again. He owns many more stocks than I do

— and is far less interested in the underlying nature

of the business; I don’t seem to have very much

influence on Walter. That’s one of his strengths; no

one has much influence on him.”

The following question is how many stocks in a

portfolio are considered diversified? We turned to

the academics for the answers.

We have to define two types of risks.

This is also known as the market risk. You may have

experienced good stocks coming down in price when

the overall stock market is weak, and stocks with bad

fundamentals can still go up if the stock market is

bullish.

Hence, regardless of what stocks you have picked,

their price movements are also affected by the overall

market sentiment.

Systematic Risk

This type of risk is more stock- or industry-specific.

For example, a company is fraudulent in nature and

the effect of the collapse of this company only affects

the shareholders of this stock and not the entire stock

market. Or it can be a particular industry that is

undergoing a bear cycle and hence most, if not all,

the stocks in that industry would be affected.

With reference to the chart below, it is evident that

the systematic risk of the stock market is the

minimum risk we must accept when we invest in

stocks. This risk cannot be diversified away.

Unsystematic Risk

However, if we are able to build a portfolio of stocks

that are of various industries, we would be able to

reduce our investment exposure to unsystematic

risks.

As we add more stocks, the unsystematic risk reduces

exponentially. This means that we do not need a lot

of stocks to achieve a good diversification.

The Modern Portfolio Theory (MPT) has dominated

the way we plan finances since it was made popular

decades ago.

Diversifying By Factors

The Theory advocates asset allocation – diversifying

our capital into stocks, bonds and cash. If we are

more aggressive and willing to take more risk, we

should have a higher proportion in stocks. Else, we

should have a bigger proportion of bonds and cash in

the portfolio.

We are able to diversify further and reap higher

investment gains after the discovery of Factors.

Currently most of the Factors apply to stocks but

research is catching up with Factors for bonds too.

Below is a pictorial depiction of a multi-asset and

multi-factor portfolio.

Larry Swedroe and Andrew Berkin backtested a

multi-factor portfolio comprising various Factors in

their book, Your Complete Guide To Factor-based

Investing. They found that any combination of

Factors performed better than a single Factor alone.

The possibility of underperforming the market

reduces by 3 to 4 times as you combine more Factors

in a Portfolio. This is because one particular Factor

may not produce the best performance all the time.

Value could dominate the returns for a few years

while Profitability lagged, but all of a sudden Value

could lose its shine and Profitability reigns. Lack of

the ability to know which Factors would perform

well, a prudent approach is to diversify by Factors.

Larry Swedroe Andrew Berkin

Your Complete Guide to Factor-Based Investing: The Way Smart Money Invests Today by

Larry Swedroe and Andrew Berkin

In finer details, we have observed that CNAV and

GPAD are very different stocks.

CNAV (Value and Size) would focus on asset-heavy

companies such as property stocks while GPAD

(quality) would penalise them. GPAD would benefit

asset-light companies like F&B and healthcare while

CNAV would not value them highly.

This means a portfolio that uses both strategies

would have more options to diversify.

The returns and risks were impressive when value

and quality stocks were combined, as discovered by

Novy-Marx,

“An investor running the two strategies together

would capture both strategies’ returns, 0.71% per

month, but would face no additional risk. The

monthly standard deviation of the joint strategy,

despite having positions twice as large as those of

the individual strategies, is only 2.89%, because the

two strategies’ returns have a correlation of -0.57

over the sample.”

The non-correlation is an important consideration

for portfolio construction. Value stocks do not work

all the time and we would like quality to work well to

compensate. Novy-Marx added that,

“Profitability performed poorly from the mid-1970s

to the early-1980s and over the middle of the 2000s,

while value performed poorly over the 1990s.

Profitability generally performed well in periods

when value performed poorly, while value generally

performed well in the periods when profitability

performed poorly. As a result, the mixed

profitability-value strategy never had a losing five-

year period over the sample.”

In a nutshell, Factor-Based Investing is the new

frontier of investing and investors should be open to

explore how it could help you lower risks and

increase returns.

While asset allocation still plays an important role,

tilting your portfolio towards a variety of well-

established Factors could help you reach your

financial goals faster.

Before you go

I hope this book has given you valuable insights to

investing in today’s markets. We keep the web

version up to date, so click here to read the latest!

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investing in our investing strategy and it has paid off,

even through Covid-19. If reading is not your thing

and you prefer to learn directly from someone, we

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